Financial Liberalization and Inflationary Dynamics in the Context of a Small Open Economy

The paper develops a short-run model of a small open financially repressed economy characterized by unorganized money markets, capital good imports, capital mobility, wage indexation, and flexible exchange rates. The analysis shows that financial liberalization, in the form of an increased rate of interest on deposits and tight monetary policy, unambiguously and unconditionally causes deflation. Moreover, the results do not depend on the degree of capital mobility and structure of wage setting. The paper recommends that a small open developing economy should deregulate interest rates and tighten monetary policy if reducing inflation is a priority. The pre-requisite for such a policy, however, requires the establishment of a flexible exchange rate regime.

Monetary Policy in a Portfolio Balance Model with Endogenous Physical Capital

We develop a portfolio balance model with real capital accumulation. The introduction of real capital as an asset as well as a good produced and demanded by firms enriches extant portfolio balance models of exchange rate determination. We show that expansionary monetary policy causes exchange rate overshooting, not once, but twice; the secondary repercussion comes through the reaction of firms to changed asset prices and the firms' decisions to invest in real capital. The model sheds further light on the volatility of real and nominal exchange rates, and it suggests that changes in corporate sector profitability may affect exchange rates through portfolio diversification in corporate securities.

International Money and Finance

We discuss the effectiveness of pegged exchange rate regimes from an historical perspective, drawing conclusions for their effectiveness today. Starting with the classical gold standard period, we point out that a succession of pegged regimes have ended in failure; except for the first, which was ended by the outbreak of World War I, all of the others we discuss have been ended by adverse economic developments for which the regimes themselves were partly responsible. Prior to World War II the main problem was a shortage of monetary gold that we argue is implicated as a cause of the Great Depression. After World War II, more particularly from the late-1960s, the main problem has been a surfeit of the main international reserve asset, the US dollar. This has led to generalized inflation in the 1970s and into the 1980s. Today, excessive dollar international base money creation is again a problem that could have serious consequences for world economic stability.